FIXED INCOME COMMENT-"The Direction is Up!"
Global growth in the first half of the year averaged 3.5%, the best since 2014. In fact, the International Monetary Fund recently raised their GDP growth estimates for 2017 and 2018. Strong performances of many G7 nations are eliminating a lot of the excess capacity faster than anticipated. This improvement has prompted several central banks to shift to a more hawkish tone surrounding interest rates. This has been seen through various press releases and speeches by central banks in the past few weeks. Currently, Canada and the U.S. are on a monetary tightening path. There are signs both the Bank of England (BoE) and the European Central Bank (ECB) are shifting gears and moving towards monetary tightening as well.
The European Union maintained economic momentum in the first half of the year with a widespread recovery across many regions surprising many forecasters. Economic growth has been accredited to strong domestic demand, supported by low interest rates and fiscal spending. GDP in the first half of the year came in at 2.4%, double estimates. As a result, the ECB is considering removing a portion of their monetary stimulus at their next meeting on October 26th. However, don’t get too excited; although growth has remained robust, inflationary pressures have not been present. The ECB has made it clear their monetary tightening will be gradual and data dependent- a page out of the Federal Reserve book.
Although Brexit is still an area of concern, the BoE recently changed their narrative regarding monetary policy. The BoE is considering removing the emergency stimulus put in place after the referendum vote. Although economic performance has been below trend, it has remained stable. It is anticipated the BoE will raise rates once this year and then be on hold during 2018.
U.S. GDP during the first half of the year came in at 2.1%. Many believed inflation would tick higher towards the Fed’s 2% target however, this has not transpired year to date. U.S. bond yields continue to be constrained by mediocre growth and lukewarm inflation. The Federal Reserve has revised their terminal Feds Funds Rate down 25 basis points from 3% to 2.75% (See circles on Fed Dot Plot). The terminal Fed Funds Rate is what economists call the neutral interest rate. It is the rate that is consistent with full employment and stable prices. The Fed is expected to raise the Fed Funds Rate by 0.25% basis points in December to 1.5%. In 2018 it is anticipated the Fed will raise rates 2 or 3 more times, again data dependent. Examining 10-year U.S. Treasury yields, they have been held within a trading range of 2.01% - 2.63% in 2017, the tightest trading range since 1965 (historical average approx. 175 basis points). The median consensus for the 10-year bond yield at year end is 2.48%. As of September 30th, it closed at 2.33%-not much more to go!
Unlike the U.S., Canada has had a blockbuster third quarter. The Bank of Canada (BoC) not only surprised the market with a complete reversal on their dovish tone surrounding the economy but, followed it up with not one, but two rate hikes bringing the overnight rate to 1%. Although the economy is experiencing above potential growth, inflation remains subdued. Furthermore, we have seen the dollar appreciate significantly over the past few months which should put downward pressure on our exports. Recently there has been much debate over the BoC’s monetary tightening mood. It is anticipated the BoC will raise the overnight rate 0.25% by year end bringing the overnight rate to 1.25%. As of September 30th, 10-year Government of Canada’s were trading at 2.10%. We expect them to trade within a range of 2-2.3% until year end.
In the short-term, the path to normalization of monetary policy is clear-the direction for interest rates is up! Central banks are committed to reversing the emergency low interest rates put in place after the financial crisis. As mentioned previously, they are putting more bullets in their monetary policy gun which they can use in case of another economic slowdown. The medium/long term the outlook is more uncertain. There are several factors to consider; inflation statistics, geopolitical events and future global growth. Are we now in a 3% growth world? Should central banks revise down their neutral rate policies further post financial crisis?
With the uncertainties in the medium to long term outlook, we have seen the yield curve flatten this year. The short end has come up reflecting market confidence in the economic outlook however; the long end has remained relatively stable due to the foggy picture for global inflation.
Bottom line: Going forward, interest rates will rise slowly. As a result, we will have a defensive position in the term structure of our bond portfolios. They will be slightly shorter than the benchmark with a laddered maturity structure. Where possible, we will emphasize Corporate and Provincial bonds over Federal Government bonds as the yields are higher.